What Is an Acquisition Premium?

An acquisition premium is a figure that’s the difference between the estimated real value of a company and the actual price paid to acquire it. An acquisition premium represents the increased cost of buying a target company during a merger and acquisition (M&A) transaction.

There is no requirement that a company pay a premium for acquiring another company; in fact, depending on the situation, it may even get a discount.

Understanding Acquisition Premiums

In an M&A scenario, the company that pays to acquire another company is known as the acquirer, and the company to be purchased or acquired is referred to as the target firm.

Reasons For Paying An Acquisition Premium

Typically, an acquiring company will pay an acquisition premium to close a deal and ward off competition. An acquisition premium might be paid, too, if the acquirer believes that the synergy created from the acquisition will be greater than the total cost of acquiring the target company. The size of the premium often depends on various factors such as competition within the industry, the presence of other bidders, and the motivations of the buyer and seller.

How Does An Acquisition Premium Work?

When a company decides that it wants to acquire another firm, it will first attempt to estimate the real value of the target company. For example, the enterprise value of Macy’s, using data from its 2017 10-K report, is estimated at $11.81 billion. After the acquiring company determines the real value of its target, it decides how much it is willing to pay on top of the real value so as to present an attractive deal to the target firm, especially if there are other firms that are considering an acquisition.

In the example above an acquirer may decide to pay a 20% premium to buy Macy’s. Thus, the total cost it will propose would be $11.81 billion x 1.2 = $14.17 billion. If this premium offer is accepted, then the acquisition premium value will be $14.17 billion – $11.81 billion = $2.36 billion, or in percentage form, 20%.

Arriving at the Acquisition Premium

You also may use a target company’s share price to arrive at the acquisition premium. For instance, if Macy’s is currently trading at $26 per share, and an acquirer is willing to pay $33 per share for the target company’s outstanding shares, then you may calculate the acquisition premium as ($33 – $26)/$26 = 27%.

Using our price-per-share example, let’s assume that there was no premium offer on the table and the agreed-upon acquisition cost was $26 per share. If the value of the company drops to $16 before the acquisition becomes final, the acquirer will find itself paying a premium of ($26 – $16)/$16 = 62.5%.

Acquisition Premiums in Financial Accounting

In financial accounting, the acquisition premium is known as goodwill—the portion of the purchase price that is higher than the sum of the net fair value of all of the assets purchased in the acquisition and the liabilities assumed in the process. The acquiring company records goodwill as a separate account on its balance sheet.

Goodwill factors in intangible assets like the value of a target company’s brand, solid customer base, good customer relations, healthy employee relations, and any patents or proprietary technology acquired from the target company. An adverse event, such as declining cash flows, economic depression, increased competitive environment and the like can lead to an impairment of goodwill, which occurs when the market value of the target company’s intangible assets drops below its acquisition cost. Any impairment results in a decrease in goodwill on the balance sheet and shows as a loss on the income statement.

An acquirer can purchase a target company for a discount, that is, for less than its fair value. When this occurs, negative goodwill is recognized.

What Is Absolute Advantage?

Absolute advantage is the ability of an individual, company, region, or country to produce a greater quantity of a good or service with the same quantity of inputs per unit of time, or to produce the same quantity of a good or service per unit of time using a lesser quantity of inputs, than its competitors.

Absolute advantage can be accomplished by creating the good or service at a lower absolute cost per unit using a smaller number of inputs, or by a more efficient process.

Understanding Absolute Advantage

The concept of absolute advantage was developed by 18th-century economist Adam Smith in his book The Wealth of Nations to show how countries can gain from trade by specializing in producing and exporting the goods that they can produce more efficiently than other countries. Countries with an absolute advantage can decide to specialize in producing and selling a specific good or service and use the generated funds to purchase goods and services from other countries.

Smith argued that specializing in the products that they each have an absolute advantage in and then trading the products can make all countries better off, as long as they each have at least one product for which they hold an absolute advantage over other nations.

Absolute advantage explains why it makes sense for individuals, businesses, and countries to trade with each other. Since each has advantages in producing certain goods and services, both entities can benefit from the exchange.

This mutual gain from trade forms the basis of Smith’s argument that specialization, the division of labor, and subsequent trade lead to an overall increase in prosperity from which all can benefit. This, Smith believed, was the root source of the eponymous “Wealth of Nations.”

Absolute Advantage vs. Comparative Advantage

Absolute advantage can be contrasted with comparative advantage, which is when a producer has a lower opportunity cost to produce a good or service than another producer. An opportunity cost is the potential benefits an individual, investor, or business misses out on when choosing one alternative over another.

Absolute advantage leads to unambiguous gains from specialization and trade only in cases where each producer has an absolute advantage in producing some good. If a producer lacks any absolute advantage, then Adam Smith’s argument would not necessarily apply.

However, the producer and its trading partners might still be able to realize gains from trade if they can specialize based on their respective comparative advantages instead. In his book On the Principles of Political Economy and Taxation, David Ricardo argued that even if a country has an absolute advantage over trading many kinds of goods, it can still benefit by trading with other countries if that have different comparative advantages.

Assumptions of the Theory of Absolute Advantage

Both Smith’s theory of absolute advantage, and Ricardo’s theory of comparative advantage, rely on certain assumptions and simplifications in order to explain the benefits of trade.

Barriers to Trade

Both theories assume that there are no barriers to trade. They do not account for any costs of shipping or additional tariffs that a country might raise on another’s imported goods. In the real world, though, shipping costs impact how likely both the importer and exporter are to engage in trade. Countries can also leverage tariffs to create advantages for themselves or disadvantages for competitors.

Factors of Production

Both theories also assume that the factors of production are immobile. In these models, workers and businesses do not relocate in search of better opportunities. This assumption was realistic in the 1700s.

In modern trade, however, globalization has now made it easy for companies to move their factories abroad. It has also increased the rate of immigration, which impacts a country’s available workforce. In some industries, businesses will work with governments to create immigration opportunities for workers that are essential to their business operations.

Consistency and Scale

More crucially, these theories both assume that a country’s absolute advantage is constant and scales equally. In other words, it assumes that producing a small number of goods has the same per-unit cost as a larger number and that countries are unable to change their absolute advantages.

In reality, countries often make strategic investments to create greater advantages in certain industries. Absolute advantage can also change for reasons other than investment. Natural disasters, for example, can destroy farmland, factories, and other factors of production.

Pros and Cons of Absolute Advantage

One advantage of the theory of absolute advantage is its simplicity: The theory provides an elegant explanation of the benefits of trade, showing how countries can benefit by focusing on their absolute advantages.

However, the theory of comparative advantage does not fully explain why nations benefit from trade. This explanation would later fall to Ricardo’s theory of comparative advantage: Even if one country has an absolute advantage in both types of goods, it will still be better off through trade. In other words, if one country can produce all goods more cheaply than its trading partners, it will still benefit by trading with other countries.

Also, as explained earlier, the theory also assumes that absolute advantages are static—a country cannot change its absolute advantages, and they do not become more efficient with scale. Actual experience has shown this to be untrue: Many countries have successfully created an absolute advantage by investing in strategic industries.

In fact, the theory has been used to justify exploitative economic policies in the postcolonial era. Reasoning that all countries should focus on their advantages, major bodies like the World Bank and IMF have often pressured developing countries to focus on agricultural exports, rather than industrialization. As a result, many of these countries remain at a low level of economic development.

Example of Absolute Advantage

Consider two hypothetical countries, Atlantica and Pacifica, with equivalent populations and resource endowments, with each producing two products: guns and bacon. Each year, Atlantica can produce either 12 tubs of butter or six slabs of bacon, while Pacifica can produce either six tubs of butter or 12 slabs of bacon.

Each country needs a minimum of four tubs of butter and four slabs of bacon to survive. In a state of autarky, producing solely on their own for their own needs, Atlantica can spend one-third of the year making butter and two-thirds of the year making bacon, for a total of four tubs of butter and four slabs of bacon.

Pacifica can spend one-third of the year making bacon and two-thirds making butter to produce the same: four tubs of butter and four slabs of bacon. This leaves each country at the brink of survival, with barely enough butter and bacon to go around. However, note that Atlantica has an absolute advantage in producing butter and Pacifica has an absolute advantage in producing bacon.

If each country were to specialize in their absolute advantage, Atlantica could make 12 tubs of butter and no bacon in a year, while Pacifica makes no butter and 12 slabs of bacon. By specializing, the two countries divide the tasks of their labor between them.

If they then trade six tubs of butter for six slabs of bacon, each country would then have six of each. Both countries would now be better off than before, because each would have six tubs of butter and six slabs of bacon, as opposed to four of each good which they could produce on their own.

The Bottom Line

The theory of absolute advantage represents Adam Smith’s explanation of why countries benefit from trade, by exporting goods where they have an absolute advantage and importing other goods. While the theory is an elegant and simple illustration of the benefits of trade, it did not fully explain the benefits of international trade. That would later fall to David Ricardo’s theory of comparative advantages.

What Is Active Management?

The term active management means that an investor, a professional money manager, or a team of professionals is tracking the performance of an investment portfolio and making buy, hold, and sell decisions about the assets in it. The goal of any investment manager is to outperform a designated benchmark while simultaneously accomplishing one or more additional goals such as managing risk, limiting tax consequences, or adhering to environmental, social, and governance (ESG) standards for investing. Active managers may differ from other is how they accomplish some of these goals.

For example, active managers may rely on investment analysis, research, and forecasts, which can include quantitative tools, as well as their own judgment and experience in making decisions on which assets to buy and sell. Their approach may be strictly algorithmic, entirely discretionary, or somewhere in between.

By contrast, passive management, sometimes known as indexing, follows simple rules that try to track an index or other benchmark by replicating it. Those who advocate for passive management maintain that the best results are achieved by buying assets that mirror a particular market index or indexes. Their contention is that passive management removes the shortfalls of human biases and that this leads to better performance. However, studies comparing active and passive management have only served to keep the debate alive about the respective merits of either approach.

Understanding Active Management

Investors who believe in active management do not support the stronger forms of the efficient market hypothesis (EMH), which argues that it is impossible to beat the market over the long run because all public information has already been incorporated in stock prices.

Those who support these forms of the EMH insist that stock pickers who spend their days buying and selling stocks to exploit their frequent fluctuations will, over time, likely do worse than investors who buy the components of the major indexes that are used to track the performance of the wider markets over time. But this point of view narrows investing goals into a single dimension. Active managers would contend that if an investor is concerned with more than merely tracking or slightly beating a market index, an active management approach might be better suited for the task.

Active managers measure their own success by measuring how much their portfolios exceed (or fall short of) the performance of a comparable unmanaged index, industry, or market sector.

For example, the Fidelity Blue Chip Growth Fund uses the Russell 1000 Growth Index as its benchmark. Over the five years that ended June 30, 2020, the Fidelity fund returned 17.35% while the Russell 1000 Growth Index rose 15.89%. Thus, the Fidelity fund outperformed its benchmark by 1.46% for that five-year period. Active managers will also assess portfolio risk, along with their success in achieving other portfolio goals. This is an important distinction for investors in retirement years, many of whom may have to manage risk over shorter time horizons.

Strategies for Active Management

Active managers believe it is possible to profit from the stock market through any of a number of strategies that aim to identify stocks that are trading at a lower price than their value merits. Their strategies may include researching a mix of fundamental, quantitative, and technical indications to identify stock selections. They may also employ asset allocation strategies aligned with their fund’s goals.

Many investment companies and fund sponsors believe it’s possible to outperform the market and employ professional investment managers to manage the company’s mutual funds. They may see this as a way to adjust to ever-changing market conditions and unprecedented innovations in the markets.

Disadvantages of Active Management

Actively managed funds generally have higher fees and are less tax-efficient than passively managed funds. The investor is paying for the sustained efforts of investment advisers who specialize in active investment, and for the potential for higher returns than the markets as a whole.

An investor considering active management should take a hard look at the actual returns after fees of the manager.

Advantages of Active Management

A fund manager’s expertise, experience, and judgment are employed by investors in an actively managed fund. An active manager who runs an automotive industry fund might have extensive experience in the field and might invest in a select group of auto-related stocks that the manager concludes are undervalued.

Active fund managers have more flexibility. There is more freedom in the selection process than in an index fund, which must match as closely as possible the selection and weighting of the investments in the index.

Actively managed funds allow for benefits in tax management. The flexibility in buying and selling allows managers to offset losers with winners.

Managing Risk

Active fund managers can manage risks more nimbly. A global banking exchange-traded fund (ETF) may be required to hold a specific number of British banks. That fund is likely to have dropped significantly following the shock Brexit vote in 2016. An actively managed global banking fund, meanwhile, might have reduced its exposure to British banks due to heightened levels of risk.

Active managers can also mitigate risk by using various hedging strategies such as short selling and using derivatives.

Active Management Performance 

There is plenty of controversy surrounding the performance of active managers. Their success or failure depends largely on which of the contradictory statistics is quoted.

Over 10 years ending in 2021, active managers who invested in domestic small growth stocks were most likely to beat the index. A study showed that 88% of active managers in this category outperformed their benchmark index before fees were deducted.

What Are Accounts Receivable (AR)?

Accounts receivable (AR) are the balance of money due to a firm for goods or services delivered or used but not yet paid for by customers. Accounts receivable are listed on the balance sheet as a current asset. Any amount of money owed by customers for purchases made on credit is AR.

Understanding Accounts Receivable

Accounts receivable refer to the outstanding invoices that a company has or the money that clients owe the company. The phrase refers to accounts that a business has the right to receive because it has delivered a product or service. Accounts receivable, or receivables, represent a line of credit extended by a company and normally have terms that require payments due within a relatively short period. It typically ranges from a few days to a fiscal or calendar year.

Companies record accounts receivable as assets on their balance sheets because there is a legal obligation for the customer to pay the debt. They are considered a liquid asset, because they can be used as collateral to secure a loan to help meet short-term obligations. Receivables are part of a company’s working capital.

Furthermore, accounts receivable are current assets, meaning that the account balance is due from the debtor in one year or less. If a company has receivables, this means that it has made a sale on credit but has yet to collect the money from the purchaser. Essentially, the company has accepted a short-term IOU from its client.

Accounts Receivable vs. Accounts Payable

When a company owes debts to its suppliers or other parties, these are accounts payable. Accounts payable are the opposite of accounts receivable. To illustrate, imagine Company A cleans Company B’s carpets and sends a bill for the services. Company B owes them money, so it records the invoice in its accounts payable column. Company A is waiting to receive the money, so it records the bill in its accounts receivable column.

Benefits of Accounts Receivable

Accounts receivable are an important aspect of a business’s fundamental analysis. Accounts receivable are a current asset, so it measures a company’s liquidity or ability to cover short-term obligations without additional cash flows. 

Fundamental analysts often evaluate accounts receivable in the context of turnover, also known as accounts receivable turnover ratio, which measures the number of times a company has collected on its accounts receivable balance during an accounting period. Further analysis would include assessing days sales outstanding (DSO), the average number of days that it takes to collect payment after a sale has been made.

Example of Accounts Receivable

An example of accounts receivable includes an electric company that bills its clients after the clients received the electricity. The electric company records an account receivable for unpaid invoices as it waits for its customers to pay their bills. 

Most companies operate by allowing a portion of their sales to be on credit. Sometimes, businesses offer this credit to frequent or special customers that receive periodic invoices. The practice allows customers to avoid the hassle of physically making payments as each transaction occurs. In other cases, businesses routinely offer all of their clients the ability to pay after receiving the service.